Biotech for non-biotech investors
Charts have nuthin' on me, baby
Tea-leaf-readers appear to be more concentrated at the 'Ville than the audiences that normally read our work. Since I have some familiarity with charting from the predecessor site to Biotech Monthly, I thought I'd take a quick detour and write about charts and biotech companies. This is a complicated subject with many, many facets, so my goal is not to give you hard and fast guidelines. Rather, my goal is to give you something to ponder the next time a chart scan leads you to press the buy/short button on a biotech stock.
Before I communicate my views on biotech and charting, I have to digress a little...
When I lecture to university undergrads and MBA students about technical analysis, the simple definition I provide to them is that charting is a mathematical representation of the relationship between volume, price, and time. While technically correct, that doesn't really get them anywhere and they retain that sleepy-eyed look inherent to over-worked college students. When I tell them it is a mathematical representation of investor psychology and a mathematical representation of insider information, then they get that bright-eyed look. I know I've got them hooked.
I would argue that Regulation FD has decreased the predictive power of technical analysis because it has reduced the number of people who get information ahead of the broader market. Where before an analyst, for example, could get a jump for his/her clients by being a favorite of the CFO or IR director, now that jump is more likely to require hard work and keen insight. The sad fact is fewer analysts posses the insight gene than the ingratiating gene. Without easy access to inside knowledge, under-the-radar buying in a stock is less likely to reach the critical mass necessary to provide chartists advance notice of a move.
Biotech remains one of the few (only?) areas in the market where Reg. FD is still broadly ignored. While nearly all companies hold to it religiously, their inseparable associates in the scientific community remain either ignorant of it or flat-out flaunt their ability to break the spirit of the rule. Hence, technical analysis of biotechnology stocks can actually provide more of a traditional technical picture than one generally sees elsewhere in the market.
The Minx is dandy at confounding people, and she's busy in biotech. Charting is about playing the odds. A good chartist is right about 60-65% of the time, but makes more money than those percentages suggest because he or she limits losses and lets winners run. It's all about stops - stop losses and trailing stops.
In biotech, you can get these beautifully predictive chart patterns. The patterns tend to become very clear just before monster bursts in the stock. To a die-hard chartist, these charts patterns are about the most beautiful thing going, with apologies to our own Miss Daisy.
The rhythm is gonna get you
I've already outlined how biotech investing is all about rhythm. The sector is extraordinarily news driven and that news shocks far more often than it delights. When either happens, the break in the stock is so violent that it runs through any reasonable, chart-based stops. That's fine if you read the chart in the right direction, but a monster (50% is not uncommon) move the wrong way can wipe out months of the typically incremental successes a daytrading or swing-trading chartist usually operates with.
Let's look at two charts:
This chart is for Discovery Labs (DSCO:NASD) up to November 21, 2003.
In the top window, you can see a decisive break of a support trend line. In the center window, you can see the break came on super high volume (2.66 million shares). In the lower window, you see two representations of money flow, both showing negative. This wasn't a perfect short setup since the stock closed in the upper half of the range on the 21st, but it wasn't bad.
What you didn't know on 11/21, unless you were very familiar with this stock, is the company was due to release news on a pivotal Phase III trial. On November 22nd, the stock opened at $6.19, got as low as $5.82, and closed at $6.78 on 1.2M volume. On 11/23, the first trading day after the news announcement, the stock opened at $8.46 (+25% overnight jump) and closed at $8.09, never trading lower than $7.76 on 9.9M shares
In retrospect, I can respect an argument stating the short would have been covered for an incremental loss intraday on the 21st or on the 22nd when the stock broke back above the trend line. What I want you to take from this, however, is a reasonable-looking short candidate went all kinds of wrong because the position was taken too close to a news event.
Chart number two is for Forbes Medi-Tech (FMTI:NASD):
Here we have a chart where the stock is rising on rising volume. The fast stochastics (daily 5,5,3 - not pictured) are slightly oversold and the money flow (bottom window) is green and gaining. This is a nice looking chart, captured here at Friday, April 2, 2004. Unless you closely followed the company, you probably would not be aware of an impending release of important Phase II trial data.
April 5th brought considerable nastiness, a decline of 79 cents on 5M shares to $7.06. News on the trial was released after hours on the 5th. The next day, the stock opened at $3.36 and closed at $3.33, never going above $3.56. This was a 53% decline on 7.1M shares.
Again, I could be persuaded by the fact the reversal day on Monday would have gotten you out of this stock. If you decided to hang around based on the good pattern from Friday, you were immolated on Tuesday.
At the least, these two charts should demonstrate the need to have a particularly short leash on short-term biotech trades based on technical analysis. They should also illustrate the explosive moves these stocks are capable of when positive or negative news is released. If you are going to trade biotechs based on chart patterns, take some extra time to understand if the chart pattern you see is in reaction to past news or imminent release of new news.
One obvious solution to the hazards of entering just before news is released is to play the post-news breakouts. But a breakout play in biotech is FAR different than a breakout play in any other stock. For example, good clinical trial news from a biotech company might cause a breakout. The next news for that company, however, might be in two years when the next clinical trial results are known. What will sustain that breakout in the meantime? Contrast that to a technology company that has a breakout because they beat Street EPS earnings. The next news for that tech company is in three months at the next quarterly earnings report.
You might argue this is a function of time horizon, but short-term traders of biotech breakouts need to realize longer-term biotech investors are well aware of biotech's rhythms. Some news is so broadly anticipated that it is faded mercilessly as big fundamental players cash in on their good fortune. Selling the news certainly happens in other sectors, but other sectors rarely have their news gestation periods measured in years.
What about rewarding good news?
Ah, yes. Rule #4. Those paying close attention probably just went "yeahbut... didn't you say successful biotech investing was all about buying rallies?
Thanks for the question, and yes I did. Look at any biotech chart over a period of years and they look a lot like stairs. When good information is released, the stock will step up to new levels. During that step-up period, the best value is often not immediately after the news is released (at the breakout). There is almost always a pullback. Those pullbacks are the place to add on the rally - or at least do the majority of any additions. Gauging the depth and duration of that pullback is, in fact, one of the best uses of charting for biotech investing.
There are as many ways to profit in the biotech sector as there are in any sector. Day traders, swing traders, and fundamentalists all do well in the sector I call home. If you're new to our neighborhood, however, I hope I've shed some light on the important differences you'll encounter. Now you know and, like GI Joe says, "knowing is half the battle."
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